Via the excellent Damien Boey at Credit Suisse:
Ahead of this week’s Fed meeting, many commentators are now debating whether officials will deliver a hawkish cut. Money markets are suggesting that the Fed is near-certain to cut rates by 25bps (90%+ probability), with the only question being whether its forward guidance is hawkish or dovish.
There are clear signs in the data, that the economy is not headed into recession:
- The most bearish data points have been the ISM surveys, which collectively pointed to stagnation in September. Retail sales also weakened in September, partly because of upward revisions to prior months’ data and unfavourable comparables.
- But more recently, we have seen regional Fed manufacturing surveys for October bounce on average. Notwithstanding the September dip, trend retail sales growth has been quite robust, at an above-average pace. And loan demand has been quite strong, consistent with the Fed’s Senior Loan Officers’ Survey.
On the basis of economic data alone, one might come to the reasonable conclusion that the Fed will deliver a hawkish cut – a 25bps rate cut, combined with upbeat forward guidance (possibly hinting at no more rate cuts in 2019). However, the real economy is one thing – financial markets are another. Lingering signs of stress in secured (or repo) funding markets are likely to keep Fed officials up at night for a little while longer. From an investment perspective, the drying up of liquidity in repo markets is both the best, and worst thing that could happen. It is the best thing, in the sense that it keeps the Fed on the back foot for longer, consistent with easier monetary policy settings, and lower for longer rates. It is the worst thing, in the sense that longer-term, liquidity problems, combined with extremely stretched asset valuations, could be a recipe for disaster. And in between these horizons, we have to worry about the US elections, and the anti-Wall Street policies of (potential) Democrat nominee and Senator Elizabeth Warren.
Money, and shadow money
As background, recall that that there are various forms of money in the economy. At one level, we have deposits, which members of the general public use to transact with each other. At another level, we have interbank reserves, which banks, and central banks use to transact with one another. Technically speaking, deposits and reserves exist in parallel universes, and therefore never mix. This is why it is technically incorrect to say that quantitative easing is printing money, because it expands the supply of interbank reserves, but has no direct impact on deposits in the system. Deposits and reserves are the most well-known forms of money. But there are other forms of money, or more precisely money substitutes in the system. Gold and digital currencies are high on this list. But also, securities are on the list. High quality sovereign, corporate, and mortgage bonds are very liquid, and can be easily exchanged for cash, or treated as a near-cash equivalent, for a very small haircut. Repo markets are about secured borrowing and lending – that is, using high quality securities as collateral for short-term financing. Recent money market stresses have been in these particular funding markets.
During the global financial crisis, secured funding markets stopped functioning because a credit issue created a liquidity issue. That is, investors started to question the value of mortgage and corporate bonds, as well as various baskets and derivatives of these, because of rising defaults. Therefore, they stopped trusting these securities as forms of collateral for repo transactions, and repo market liquidity therefore dried up as a result of inadequate collateral supply. The Fed tried to fix these problems in the first instance by injecting more high quality securities into the market. But it failed, because the extent of credit problems in the system meant that more “shadow money” was being destroyed by the crisis than the Fed could create in a short space of time. Therefore, the Fed had to resort to its last resort option of quantitative easing, while the US Treasury tried to create money (deposits) through large scale fiscal deficit spending.
This time around, secured funding markets have been stressed by capital regulations, rather than credit problems. Basel III has created a more onerous global reserve requirement through capital regulation, over and above the Fed’s local liquidity requirement. It has done so by creating the perception that interbank reserves are of greater worth than US Treasuries and the like in terms of liquidity value to meet more onerous capital requirements. Therefore, banks have tried to hoard reserves, even as the Fed has tried to take them off their hands through its balance sheet reduction and tightening efforts. Moreover, the US Treasury has been sucking out reserves through large scale bond issuance, as it has attempted to navigate constraints imposed by the debt ceiling. A month or so ago, these forces reached their zenith, with repo rates spiking, and the Fed’s benchmark “secured overnight financing rate” (SOFR) surging as high as 5.25%, well above the Fed funds rate. In response to the liquidity crisis, the Fed commenced a series of temporary, and permanent open market operations. In other words, it started injecting more reserves into the system in exchange for securities. Importantly, it did so, without flooding the market with excess liquidity, thereby dropping the Fed funds rate to zero. But even though it technically did not re-embark upon quantitative easing, it did start expanding the size of its balance sheet again. In response to the Fed’s liquidity provision, secured funding rates have fallen back to being broadly in line with the Fed funds rate.
As we have approached month-end in October, we have seen secured funding rates remain under control. But we have seen consistent oversubscription of Fed open market operations. There has been more demand for Fed liquidity than the Fed has been willing to supply for any given period of time. Many commentators view this development as a worrying sign that eventually, stresses will return to the system, even if secured funding rates are presently under control.
The mythical solution to liquidity problems is the Standing Repo Facility (SRF). The SRF is a powerful tool that would involve the Fed being able to provide any and all liquidity to secured funding markets, without participants having to wear the stigma of seeking emergency liquidity through conventional channels. It is so powerful in fact, that the mere credibility to build this facility alone, would suffice to calm money markets. However, by the admission of Fed officials, the SRF would be incredibly complicated to design, given that much has changed in the plumbing of the Fed funds system. The Fed would need months to successfully plan, test and implement the facility – not days. So, in order to leverage credibility, and alleviate market concerns about implementation, the Fed has chosen the short-term route of rate cuts and permanent open market operations, until the SRF is operational.
So far, the Fed’s plan has worked. But enter Elizabeth Warren and the 2020 election. Among other things, Warren is opposed to dismantling some of the capital rules put in place in the aftermath of the global financial crisis, such as the liquidity coverage ratio. Investors are concerned that her policies will further stress money markets, putting even more pressure on the Fed to “pull a rabbit out of the hat”, by making the SRF operational ahead of time. And the more pressure that is put on the Fed, the more its credibility to defend the system diminishes, and the more action today will be demanded by investors to alleviate their concerns.
There is a longer term problem here too. The more investors are appeased today, the more stretched asset valuations become. And the more stretched asset valuations become across the board, the greater the risk of a major correction at a time when:
- Central banks have much less ammunition to deal with crisis.
- We could see a policy mistake. Note that when risky assets are not priced for much bad news, any shock could cause a disproportionate risk-off response, as the sensitivity is greater to bad news than good.
In the event of a major correction longer-term, we cannot rule out the risk of de-leveraging. A sharp, an unimpeded fall in asset prices could cause a major growth shock, uncovering credit quality problems in the system. Investors would interpret credit problems and tighter liquidity as correlated, if not causal events, sending financial markets into a negative feedback loop. De-leveraging would ensue, because asset prices start driving fundamentals rather than the other way around. Volatility would spike, just like it did during the financial crisis. And, subject to fiscal stimulus prospects (because of exhausted monetary policy), the world would experience a reset.
We emphasize, that this is not the outlook for today, or even the next few months. Today, we have a liquidity problem, without an obvious credit problem. But longer-term, if we still have liquidity problems, and financial markets experience a major correction, there will be a more visible credit problem to deal with, and liquidity issues will become much harder to ignore.
The Fed should be well aware of the balance of risks. The real economy does not need rate cuts today – but financial markets do. And if financial markets are not appeased, they will go into free fall, causing a real economy growth shock tomorrow, to which the Fed will have to respond with even more stimulus.
We think the Fed will choose the path of least resistance by:
- Continuing to cut rates and do what is necessary to keep funding markets in check.
- Focusing investors on the evidence that lower rates are working to support the economy (eg through recovering loan and housing demand).
- Noting various risk factors and the evolution of uncertainty.
In other words, the Fed will do its level-best to jawbone the yield curve steeper. Easing cycles usually result in short rates falling faster than long bond yields. And reflation potential could continue to support a rise in bond yields for a little while longer (at least, until passive funds really start to experience some pain).
Within the equity market, curve steepening is supportive of value investing. Equity market investors like curve steepening, because it signals that growth could be bottoming out, supporting a faster pace of mean reversion for heavily discounted stocks in anticipation of earnings recovery. To be sure, lower rates could continue to offer support for quality and defensive names as well. But because multiple dispersion between the “haves” and “have nots” is so wide, a blended value and quality portfolio still ends up having a lot of value in the long basket, and a lot of quality in the short basket. For further discussion of our investment thesis, please see our recent articles “Tail risk or apocalypse” dated 5 September 2009, and “Uncorrelate me” dated 30 August 2019.